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AFM212 > week 2 | financial analysis > Flashcards

week 2 | financial analysis Flashcards

1
Q

describe ROE & formula

A

(return on equity) Most common analysis metric used by managers & investors alike

ROE = Net Income/ Average shareholders’ equity
- Measures return from perspective of company’s stockholders

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2
Q

what does ROE do for parent company

A

ROE measures return to the controlling (parent company) stockholders

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3
Q

what is noncontrolling interests

A
  • part of a company (subsidiary) that parent company doesn’t fully own
  • reps ownership held by outside investors or minority shareholders in that company
  • Need to consolidate statements (with subsidiaries)
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4
Q

ROE formula under noncontrolling interests

A

ROE = (net income attributable to the parent company’s stockholders) / (equity attributable to the parent company’s stockholders)

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5
Q

what does ROE do for common stockholder

A

ROE measures return to the common stockholders

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6
Q

what formula does preferred stock necessitate

A

ROCE = (net income - preferred dividends) / (average stockholders’ equity - average preferred equity)

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7
Q

why is analysis done on ROE

A

Performance analysis seeks to uncover the drivers of ROE & how those drivers have trended over time to better predict future performance

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8
Q

2 methods to measure ROE drivers:

A

1.Traditional DuPont analysis that disaggregates ROE into components of profitability, productivity, & leverage
2. ROE analysis w/ an operating focus that distinguishes b/w operating & non-operating activities
- Operating activities drive shareholder value

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9
Q

dupont disaggregation of ROE (formula)

A

ROE = (net income)/(avg. stockholders’ equity) = (net income/avg total assets) [ROA] x (avg total assets/avg stockholders’ equity) [FL]

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10
Q

dupont disaggregation of ROE (explanation)

A
  • ROE reflects both
    • Company performance (as measured by ROA)
    • How assets are financed (as measured Financial Leverage)
  • ROE is higher when there is more debt & less equity for a given level of assets
  • Tradeoff → greater debt means higher risk for the company
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11
Q

ROA formula

A

ROA = net income / average total assets

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12
Q

what is ROA

A
  • ROA measures return from the perspective of the entire company (enterprise level)
  • Includes both profitability (numerator) & total company assets (denominator)
  • ROA analysis encourages managers to focus on both the IS & BS
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13
Q

how to get high ROA

A

To earn a high ROA, the company must be profitable & manage assets (hold the lowest level of assets possible to achieve the desired profit)

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14
Q

financial leverage formula

A

FL = average total assets / average stockholders’ equity

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15
Q

what is financial leverage

A
  • FL measures the relative use of debt vs equity to finance the company’s assets
  • Important → debt is a contractual obligation & a company’s failure to repay principal or interest can result in legal repercussions or even bankruptcy
  • Decision as CFO
    • Double your money in the return (leverage)
    • Better if return is above 10
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16
Q

what does Higher financial leverage mean

A
  • Higher debt & interest payments
  • All else equal, increases the probability of default & possible bankruptcy
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17
Q

disaggregation of ROA formula

A

ROA = net income / avg total assets = (net income/sales) [PM] x (sales/avg total assets) [AT]

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18
Q

what is PM

A

what the company earns on each sales dollar

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19
Q

what is AT

A

sales generated from each dollar invested in assets

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20
Q

how can managers increase ROA

A

Increase PM → increase profitability for given level of assets
Increase AT → reduce assets while still generating same profit level

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21
Q

what impacts PM & AT

A

Profit margin more impacted by competitors → affect sales
Asset turnover → decisions made by managers

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22
Q

GPM formula

A

GPM = GP / sales

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23
Q

describe GPM

A
  • Influenced by both the selling price of a company’s products & the cost to make or buy those products
  • Generally high & increasing GPM is better
  • Low or decreasing GPM signals more competition or less demand for the company’s products
    • Competitive intensity has increased product line has lost appeal
    • Product costs have increased
    • Product mix has changed
    • Volume has declined & fixed costs have not
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24
Q

what is operating expense margin

A
  • Measures general operating costs for each sales dollar
  • Consider each expense in whatever detail the company provides in its IS
  • Compare margins over time & against peers (making sure that peers have similar business models)
25
Q

general turnover

A

IS item / BS item

26
Q

asset turnover formula

A

AT = sales / avg total assets

27
Q

working capital turnover ratios

A

AR turnover
Inv’t turnover
AP turnover

28
Q

AR turnover formula

A

sales / average A/R

29
Q

inv’t turnover

A

COGS / avg inv’t

30
Q

AP turnover

A

purchase or COGS / avg AP

31
Q

ppe turnover formula

A

sales / average PPE

32
Q

analysis of PPE

A

improving PPE turnover is not easy → it often entails:
- Divesting of productive assets or entire business lines
- Joint ventures to share assets such as distribution networks, information tech, production facilities, transportation fleets, & warehouses
- Selling production facilities w/ agreements to purchase finished goods from the facilities’ new owners
- Sale & leaseback of administrative buildings
- Lease asset → operation of business

33
Q

analysis of financial leverage

A
  • Proper use of FL benefits stockholders
    • Relatively inexpensive source of capita
    • Adds risk → debt repayment is mandatory
      • Could be bad if it is too high → don’t have enough on hand for day-to-day operations
  • Analysis of FL typically involves:
    • Level of borrowed monet relative to equity capital
    • Level of profit or CF relative to required debt payments
34
Q

total liabilities to equity formula

A

total liabilities / total equity

35
Q

times interest earned formula

A

EBIT / interest expense

36
Q

what is operating focus

A
  • ROE disaggregation w/ an operating focus recognizes → companies create value mainly through core operations
  • BS & IS include both operating & non-operating items
  • ROA in the traditional DuPont method, reflects a blend of the return on a company’s operating assets & its non-operating return
  • Analysis can be improved if we separately identify the operating & non-operating components of the business & their separate returns
    • Pretty numbers to attract more shares
37
Q

ROE formula under operating focus

A

ROE = Operating return + Non-operating return

38
Q

what is operating return in the operating focus ROE formula

A
  • Return from operating activities
  • Earned from operating assets & liabilities
39
Q

what is non-operating return in the operating focus ROE formula

A
  • Return from financing & investing activities
  • Earned from non-operating assets & liabilities
40
Q

what is RNOA

A

Return on Net Operating Assets
- Operating returns are measured by return on net operating assets

41
Q

RNOA formula

A

RNOA = NOPAT / NOA

42
Q

how do you calculate average NOA

A

(NOA start of yr + NOA end of yr) / 2

43
Q

what parts of liabilities do we look at when analyzing ROE

A

borrowed money
- loans/bonds/mortgages
- interest bearing
- severe legal repercussions

operating liabilities
- AP/accurals
- interest free
- self-liquidating

The operating focus ROE treats these 2 types of liabilities differently for ROE analysis

44
Q

what does self-liquidation (operating liabilities) mean?

A

Short-term obligations, like accounts payable, that are automatically paid off through the company’s regular business operations without requiring additional financing

45
Q

NOA & formula

A

Net operating assets = operating assets - operating liabilities

46
Q

what is under operating assets in NOA

A

A/R
Inventories
Prepaid expenses/supplies
PP&E & right-of-use assets
Intangible assets & goodwill
Deferred tax assets

47
Q

what is under operating liabilities in NOA

A

Accounts payable
Accrued expenses
Unearned (deferred) revenue
Income taxes payable
Deferred tax liabilities

48
Q

what’s not in operating assets in NOA and why?

A
  • No cash in operating assets
  • Certain cash is necessary for daily business (A/P)
  • Pay salaries
  • Most cash is more than needed to support working capital needs
  • Put in short-term investments → commercial papers
49
Q

why do we split operating & non-operating?

A

Split operating and non-operating to tell whats more sustainable

49
Q

NOPAT & formula

A

Net Operating Profit After Tax = NOPBT - Tax on operating profit

49
Q

why is equity market investment not included in OA?

A

…

49
Q

NOPBT & formula

A

net operating profit before tax = sales - operating expenses = EBIT

50
Q

what is & isn’t included in operating expenses for NOPBT

A
  • COGS
  • SG&A: wages, advertising, occupancy, insurance, depreciation & amortization, litigation, & restructuring expenses
  • R&D
  • Impairments of operating assets such as goodwill
  • “Other” operating expenses or income
  • Interest
51
Q

tax on operating profit formula

A

tax on operating profit = tax expense - (pretax net operating expense * statutory tax rate) [tax shield]

52
Q

describe the tax shield

A
  • Tax shield → taxes a company saves by having tax deductible non-operating expenses, mostly interest
  • Taxes saved (by tax shield) do not relate to operating profits
  • Add back the tax shield to total tax expense to compute the tax on operating profit
53
Q

Non-operating items on the IS include

A

Interest expense on debt & lease obligations
Interest & dividend income on marketable securities
Loss or income relating to discontinued operations
Debt issuance & retirement costs
Gains or losses on sale of non-strategic investments
“Other” income or expense if reported separately from operating income
Pension income or losses

54
Q

what is the relationship b/w pretax non operating expense & income?

A
  • Most companies → non-operating activities create a pre-tax net non-operating “expense”
  • When reverse is true, the net non-operating item is “income”
55
Q

how to compare dupont & operating focus?

A

dupont: ROA/ROE
operating: RNOA/ROE

56
Q

ROA & FL discussion in comparing analysis

A
  • FL relates to the degree to which the company uses borrowed money
  • Important measure of the risk a company is incurring w/ its reliance on debt
  • Increases risk & also increases the return to shareholders if the yield on the assets ? borrowing rate on the debt

Operating approach shows that much more of Pfizer’s ROE is due to operating activities that make up its core business as opposed to FL (operating > dupont in %)

AFM212 (7 decks)

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